Is it fair to cast on investors the responsibility that founders build well-governed enterprises, asks G.Sabarinathan1
Troubled startups and their financial benefactors are back in the news again for the wrong reason. We first had the issue of a founder who allegedly waxed a little too eloquent on a phone call with his banker. Enquiry into the said founder seems to have expanded with a few arms of the government jumping into the fray, wanting to know more. Yet another company’s fund raising efforts seems to have run into trouble with unseemly revelations of their alleged creative financial practices. Not surprisingly one of the founders is said to have shot off an unpleasant letter to his investors. And the latest to be reported is an instance of alleged tax fraud by another business to business unicorn.
None of this is new to the world of early stage investing. Founders have been known to engage in what is euphemistically referred to in stuffy academic language as strategic behaviour. In plain language, founders should be expected to lie and fake, if it would buy them time with the investor, even if it were to be only short periods of time. Investors in turn have been known to protect themselves from these situations with draconian contracts and rates of return that in Indian law at least would easily cross the barriers of usury.
Private equity and venture capital – not so private any more
What is however new is the scale of these phenomena. Scale at which these issues can no longer be dismissed as private disagreements that should be left to be resolved as if they were a domestic quarrel between feuding spouses on who should do the dishes and who should do the laundry. Private equity (PE) and venture capital (VC) are now big in India. In 2021-22, these funds committed fresh funds of US $ 77 billion in 2021 and netted $ 43 billion from investments they liquidated, both being records of a sort.
To put that in perspective, compare it with commitments of $ 38.4 billion of fresh funds committed by foreign portfolio investors to the Indian market in 2020-21, and $ 15.4 billion that Indian companies raised by way of initial public offerings (IPOs). These comparisons are relevant because the belief hitherto has been that private investments are an infant cousin of their public market counterparts. Infant the industry may be in terms of relative vintage, if you trace their origins to 1988. But not so any more in terms of bulk.
The ever-growing and large foot prints of Indian startups
That is not all. The enterprises they fund impact millions of people who are their customers, or people who work for them, occasionally deceptively referred to as “partners” and a few millions more who participate in the food chain in various other ways.
Here are some pointers. Zomato counted customers in their draft red herring prospectus, 131,000 restaurants and 162,000 “delivery partners”. It counted around 45 million monthly active users aty that time. As of mid 2021, Paytm counted 7 million merchants who used their QR code, 850, 000 offline merchants used their payment services, 450 million registered users of their payment services, around 40 million monthly active users. Even a relatively new kid on the block like Bharat Pe serviced 7.5 million merchants by August 2021. As of early 2021Meesho had a network of 15 million microentrepreneurs. Many, if not most, of them are not financially robust and have turned to Meesho to shore up their fortunes. Towards the end of 2021, Oyo had 5100 employees, 159,000 hotels in its network in 10,000 cities across the world.
Businessman pressing an Capital concept button.
If things go wrong at large startups – as they have unfortunately in some of them, from time to time –it is no longer a private scurrilous squabble over family silver. If a ride hailing company plies vehicles without a permit required under local laws it is putting at risk the livelihoods of thousands of “partners”, whose finances are reported to have become parlous, even without these interruptions, what with the increase in the aggregators’ fees that newspapers have been reporting.
The pressing need for stewardship
Someone has to take responsibility for the conduct of these enterprises. To ensure that they are governed in the interests of all the stakeholders and not merely in the interests of those who seek to make a capital gain out of them. The well-established, time tested and widely accepted principle in the case of listed companies is that the Board of Directors and the senior leadership team is not accountable just to the shareholders of the enterprise, but to all the stakeholders, including the larger community in which it operates.
The extraordinary privileges of PE and VC investors
So who should provide such stewardship to private enterprises? Does anyone have a more than equal influence on the management of these enterprises? Data available in the draft red herring prospectuses of VC funded enterprises provides some answers. Insiders to the world of PE and VC although have known these answers all along.
The answer is that apart from seats that investors take on the boards of investee companies investors enjoy extraordinary privileges that are not normally provided under Indian corporate law. Such privileges extend to decisions relating to new investment, sale of assets by the enterprise, formation of business partnerships, board composition, mobilization of capital, recruitment of key personnel, stock options, vesting of founders’ shares and so on.
In short, going by the provisions, often referred to as minority protection, there is very little the management of a start up can do without the consent of the investor. If that sounds like an exaggeration one has to only peruse the memorandum and articles of association of some of these VC funded startups.
The piper and his tune
If investors wield such control over their funded enterprises and have a seat on the board of the startup, why do such unsavoury events happen? And so frequently? The answer lies in the fable that children learn in primary school.
The relationship between the investor and the founder is like that of the piper and the mayor of Hamelin. The founder is supposed to have this magical tune that controls value creation in the enterprise, in much the same way as the piper is said to have enjoyed over the rats in the fable. Humour the founder by paying his dues and you realise can fancy multiples on your investment. Incur his wrath at the risk of being left with a worthless shell of an enterprise. Or, at least that is the sense one gets when one reads popular press accounts of these enterprises that have run into difficulties.
That founders are important to the success of an enterprise is again not new in the world of early stage or VC investing. The one cliched slogan in any VC’s presentation, that is as old as the VC industry itself, is this old saw: There are three things that are essential to the success of an enterprise: Founder, founder and founder. But then there is an equally important belief, although less well known, that half of the investor’s work in an enterprise starts after the cheque has been written.
Investors in VC funds pay almost 20% of the fund corpus as a fixed management fee over the life of the fund and another 20% of the capital gains as incentive pay for the effort and expertise expected of them before the investment is made and therafter till the investor exits from the investment. That makes the VC fund one of the most expensive investment avenues, apart from the likelihood of loss of capital. Now compare that with the 0.50% and 1% that investors in mutual funds pay annually to their fund managers. The latter fees are arguably low because of the premise that the fund manager’s job consists of just identifying companies that look promising and ends with selling the shares when the companies cease to be so.
“God syndrome”
Contrary to this expected role of the VC fund manager, in the past decade or so, it appears that the part that VCs play in building portfolios of investments appears to have undergone a considerable change. Going by popular accounts of the engagement between investors and enterprises they have funded, VC investors seem to think that 80% of their work lies in finding that rock star entrepreneur and somehow inveigling him to give the fund a position in its “cap table”. (Capitalisation table or cap table for short is industry jargon for the list of shareholders in a company.) The remaining 20% lies in cheerleading these successful founders and selling the less successful investments.
As for the founders, a comment by an industry observer in an interview on the recent troubles of one of the unicorns is insightful: Founders suffer from God syndrome once they taste initial success. In their recent book, The Cult of We, Eliot Brown and Maureen Farrell note that it is this surrender of the investors’ rights at the altar of the strong founder that gave the investing world the not so happy ending at We Work. That makes one wonder, if investors had exercised their rights in time could some of the unpleasant denouements in Indian start ups have been avoided?
New player, new styles, but…
Bringing a founder in line, especially when he has had some success is not easy. Investment successes are heavily dependent on founders’ entrepreneurial aggression and performance. When does that aggression turn into dysfunctional behaviour is a hard call to make. The ability to draw that distinction is what sets apart competent investors from the not so competent.
With the arrival of a new set of players in the industry the experience that helps in managing portfolios appears to be missing. A recent article in Moneycontrol, provides a graphical description of the functioning of the founder CEO of a unicorn and the difficulty that the investors in the company seem to have in influencing his behaviour. Their guiding belief seems to be that they would just have to turn a blind eye to those quirks as long as the founder delivers revenue growth.
But that new style, that reluctance to steer the management in the direction of good governance till it is too late, can come back to the investors themselves, let alone the employees or the larger community. What is more, not exercising that responsibility of oversight would amount to a lazy way of earning the industry standard 2%-20% compensation structure that can run into tens of millions of dollars, if not more.
Is it fair to cast on investors the responsibility that founders build well-governed enterprises? The answer is an unhesitant yes. That is what they are paid to do inter alia. That is what they are believed to be capable of. They have empowered themselves contractually to be able to play that part. What use are these contractual rights if they are not utilized effecticely?
The idea of due diligence does not end with the signing of the cheque. It goes all the way to achieving an orderly and profitable exit by helping build well governed and law abiding enterprises. They need to do what it takes to achieve those objectives. He who pays the piper should call the tune. And that, by the way, should apply to the relationship between the investor in the fund, also known as the limited partner and the fund manager, also knows as the general partner.
1G. Sabarinathan, PhD teaches at IIMB. Decades ago he ran away from the Indian VC industry. About most things in life, if he is not angry he is furious.
